1

Lease Accounting Standard UpdateASU 2016-02

Presented by: Nicholas Hoefel, CPAManager, Audit Services Group

2

Overview

• Introduction• Background and current environment• Effective dates and transition• Key provisions of the new guidance• Early planning and action items

3

IntroductionThree takeaways

1. Bigger balance sheets• Most common operating leases will be added to

the balance sheet as an asset and a liability2. Additional disclosures3. Advanced planning and communication

necessary• Lenders, management and other stakeholders• Significant changes expected for commonly

used metrics and performance indicators

4

Background• Financial Accounting Standards Board (FASB) and

International Accounting Standards Board (IASB) joint discussion paper issued in 2009 – target convergence and improvement

• 1st FASB Exposure Draft – Aug 2010• Single model (capital/financing)

• 2nd FASB Exposure Draft – May 2013• Dual model reflecting different levels of consumption• Conceptual lessee model departs from IASB

• Final ASU issued Feb 2016• International Financial Reporting Standards (IFRS) 16

issued Jan 2016• Convergence partially achieved

5

Current Environment

• Operating leases not recognized on the balance sheet

• Most leases are off-balance-sheet but disclosed in footnotes

• Existing GAAP contains two very different accounting outcomes for economically similar transactions

• Users seeking transparency and comparability• Structured transactions• Inconsistent “add-backs” in the creditor and investor

community for off-balance-sheet leases• Financing and leverage comparisons between

similar firms

6

Effective Dates and Transition• Reporting years beginning after Dec. 15, 2019

• December 31, 2020 and June 30, 2021• For non-public entities, including not-for-profit entities• Early adoption is permitted• Governmental Accounting Standards Board (GASB)

expected to release guidance in 2017• Transition

• Modified retrospective approach – new and continuing leases will be affected in the implementation period

• Practical expedients to reduce burden on existing (expired or continuing) leases

• Certain carve-outs• Leases for intangible assets, mineral exploration,

biological assets, inventory and assets under construction

7

Key Provisions• Lease definition• Classifying a lease

• Financing or operating• Accounting for leases

• Initial and subsequent• Modifications

• Separating/allocating components• Lease or non-lease

• Disclosures and presentation• Other: sale-leaseback, business combinations,

real estate/structured leases

8

Lease Definition

A contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration

• Determination at inception• Only reconsidered for certain “modification” triggers

• Underlined terms subject to significant fine-print

• ASU – 10 complete examples

9

Navigating Key Decision Points

1. Is there an identified asset?• Explicit versus implicit• Supplier substitution rights

2. For the period of use, do we have the right to obtain substantially all of the economic benefits from that asset?

3. Do we have the right to direct how and for what purpose the asset is used (or is use predetermined)?

10

Classifying a LeaseClassified as either

• Short-term (generally all <12 months)• Accounting policy election to expense straight-line

over life of lease, no asset/liability recognition

• Financing – one of the following 5 tests apply1. Ownership transfers2. Exercise of purchase option reasonably certain3. Term constitutes a major part of the asset’s

remaining life4. Present value of lease payments is substantially all

of the asset fair value5. Specialized nature of asset (no future market)

• Operating – NONE of the preceding 5 tests apply

11

Accounting - Initial Measurement

• Financing and Operating Leases• Right-of-use (ROU) asset• Lease liability

• Initial measurement - present value of future lease payments, product of:

• Discount rate• Lease term• Lease payments• Lease components

12

Discount Rate

1. Implicit rate in the lease2. Incremental borrowing rate for similar

financing3. Risk-free rate (for similarly termed liability)

• Accounting policy option, must be applied to all leases

• U.S. Treasury Notes and Bonds

13

Lease Term

Noncancellable term+ lessee option term to extend, if reasonably certain+ term lessee option to terminate, if reasonably certain not to exercise+ term lessor option to extend or terminate (regardless of likelihood)

• Decisions in our control – use probability• Decisions out of our control – assume maximum

term (extensions exercised, terminations waived)

14

Lease Payments

• Fixed (or in-substance fixed) payments, less incentives

• Variable lease payments based on an index or stated rate (such as Consumer Price Index)

• Purchase option, if reasonably certain to exercise

• Termination penalties, if reasonably certain to exercise

• Residual value guarantee

** other fine-print adjustments may apply

15

Components

• Examine contracts to separate...• Lease components – one or more• Non-lease components (if any) – typically maintenance

and services bundled in the agreement

• Allocate consideration on “stand-alone” pricing• Non-lease components addressed by other

guidance• Generally expensed as incurred

• Practical expedient accounting policy available• Leads to larger ROU asset and liability

16

Accounting – Initial Measurement

• ROU asset and liability “start” at the same value

• Beginning ROU asset adjusted for:+ Initial direct costs- Lease incentives received+ (Lease payments made on/before commencement, annuity-due)

• Liability amortization remains the same over the lease term for both Financing and Operating leases

17

Subsequent Accounting

FINANCING LEASE• ROU asset – amortize straight-line over

term• P&L impact – amortization expense

• Liability accreted and amortized• P&L impact – interest expense

• Results in net acceleration of expenses

18

Illustration – Financing Lease

• Company enters three year equipment leases on Jan 1, Year1; fixed payments as follows; implicit rate is 4.235%; qualifies as financing lease

PaymentsDec31,Year1 $10,000Dec31,Year2 $12,000Dec31,Year3 $14,000

$36,000

ImplicitRate 4.235%

Presentvalue,Jan1,Year1 $33,000

19

Illustration – Financing Lease (continued)

Lease Commencement:January 1, Year1 Debit Credit

Right-of-use Asset 33,000 Lease liability 33,000

Present value of lease payments at 4.235% discount rate

First-year Accounting Entries: December 31, Year1 Debit Credit

Lease liability 8,602 Interest expense 1,398 Cash 10,000

Amortization of lease liability per schedule

Amortization expense 11,000 Right-of-use Asset 11,000

Straight-line amortization of ROU asset, $33,000 / 3 years

20

Financing Lease – Income Statement impactIncomeStatementEffectofFinancingLease

Total Amortization Interest

21

Subsequent Accounting

OPERATING LEASE• Achieve “single lease cost” on a straight-line

basis in the income statement

• Liability accredited and amortized

• ROU asset – amortized at difference between SL total and interest expense

• Results in level expense over lease term

22

Illustration – Operating Lease

• Company enters three year equipment leases on Jan 1, Year1; fixed payments as follows; implicit rate is 4.235%; qualifies as operating lease

PaymentsDec31,Year1 $10,000Dec31,Year2 $12,000Dec31,Year3 $14,000

$36,000

ImplicitRate 4.235%

Presentvalue,Jan1,Year1 $33,000

SAMEFACTPATTERNANDCALCULATIONSASFINANCINGILLUSTRATION

23

Illustration – Operating Lease (continued)

Lease Commencement:January 1, Year1 Debit Credit

Right-of-use Asset 33,000 Lease liability 33,000

Present value of lease payments at 4.235% discount rate

First-year Accounting Entries:

December 31, Year1 Debit Credit Lease liability 8,602 Cash 10,000 Rent/lease expense 12,000 Right-of-use Asset 10,602

Record payment, accretion of lease liability & adjustment of ROU asset

24

Operating Lease – Income Statement impactIncomeStatementEffectforOperatingLease

Total Interest Amortization

25

Presentation and Disclosure

BALANCE SHEET• Either (a) separate lines, or (b) together with

similarly caption elements along with footnote disclosure of lines/amounts

• Amounts for financing and operating leases CANNOT be presented in the same lines

• Amounts currently due on lease liabilities (typically next 12 months) should be classified as “current”

26

Presentation and Disclosure

INCOME STATEMENT• Financing Lease

• ROU asset amortization = amortization expense• Liability accretion = interest expense

• Operating Lease• Liability accretion and ROU asset adjustment

combined as “rent” or “lease” expense within operations

27

Presentation and Disclosure

CASH FLOWS• Financing Lease

• Principal – financing activity• Interest – operating activity• Amortization – operating activity

• Operating Lease• Single lease cost – operating activity

28

Presentation and Disclosure

New or expanded footnote disclosures• General information about the terms and conditions of

leases• Significant judgments/assumptions in identifying a lease,

separating components and applying discount rate• Finance, operating, short-term and variable lease costs• Weighted-average discount rate• Maturity analysis (separate for Financing and Operating)

and reconciliation back to balance sheet• Related party leases• Other matters: short-term leases, practical

expedient alternative elections, sale-leaseback transactions

29

Transition

Modified-retrospective approach• Practical expedient available for “existing

and expired” leases• Do not reassess definition of a lease• Do not reassess classification of a leases• Do not reassess initial direct costs

• As of beginning of earliest comparative year presented in the year of implementation

30

Transition (continued)

• Expected effect for “plain-vanilla” leases• Previous operating leases will become

OPERATING leases• Add to balance sheet at present value• NO EQUITY ADJUSTMENT

• Previous capital leases will become FINANCING leases

• Re-classification / change in captions only• NO EQUITY ADJUSTMENT

31

Transition (continued)

• Complicating factors for lessees (“non-vanilla”)• Not electing transition practical expedients

• Acquired in a business combination

• Purchase, termination or extension options

• Activities in the transition period• Modification of lease• Impairment of ROU asset• Remeasurement of lease liability

32

Lessor accounting

• Fewer overall changes made to the lessor model

• Prospective elimination of “leveraged leases” and real estate transactions possibly qualifying as sales-type leases

• More restrictive definition of “initial direct costs”• Alignment with ASC 606/revenue recognition

updates• Separation and allocation of lease/non-lease

components• Assessment of collectibility

33

Early planning considerations• Stakeholder education

• Impact on performance indicators and commonly used ratios• Debt-to-Equity (Leverage), Debt Service Coverage, ROI/ROA• EBITDA

• Implications for incentive compensation plans• Debt covenants

• Transition plan• “Inventory” of leases• Accounting policy/expedient elections• Tracking key terms and values ahead of implementation

• Planning opportunities• Limited “structuring” opportunities expected• Awareness of financial impact heading into

new lease agreements